New ETFS are poor man's hedge fund

Not one to miss a trend, the ETF industry has quickly latched on to the latest: mimicking hedge fund tactics in portfolios aimed at the little guy.

The appeal is simple: These so-called alternative ETFs, like the IQ Hedge Macro Tracker launched recently, aim to reduce the volatility of your portfolio. The goal is the holy grail of diversification, since these strategies have hardly any correlation with stocks and bonds, says Morningstar ETF analyst Bradley Kay. “For years the only real way to diversify (away from stocks) was with long-term government bonds, but that also meant a long-term drag on returns,” he says. Investing in assets like currencies and using long/short strategies can boost returns while also minimizing the stomach-churning volatility of your overall portfolio. Plus, the ETFs also come without the traditional headaches of investing directly in a hedge fund, namely high minimums, liquidity and transparency.

But diversification alone is never enough of a reason to invest in a fund, especially when it comes to sophisticated ETFs like the latest from IndexIQ.

The ETF is based on the IQ Hedge Macro Index, which mimics hedge fund returns based on a global macro and emerging market strategy, but the ETF uses a backward-looking analysis to rebalance at the end of every month. In short, it takes the hedge fund returns from the last month, say May, and restructures its portfolio in an attempt to match the strategies that worked to generate similar returns in June.

Yes, you read that right – the ETF is perpetually aping strategies executed a month ago. One obvious problem: Using monthly returns to rebalance makes it very difficult for the fund to know what the hedge funds were investing in. “If they were using daily or even weekly data then they’d have a pretty good idea, but with monthly returns you’re basically guessing,” says Kay. Adam Patti, IndexIQ’s CEO, downplays the concern. “The funds are very responsive to the changing trends,” he says. So far it’s too soon to tell.

The Elements S&P CTI ETN, which uses the hedge fund-like long/short strategy to invest in commodities, has a longer track record, albeit just a year. It tracks the S&P Commodity Trends Indicator Index, which rebalances once a month to reflect the momentum swings in a wide variety of commodities, such as oil, gold and livestock. It’s currently the only offering that has the ability to go both long and short, and that gives it the potential for better longer-term performance than funds that are stuck in just one position.